If Treasuries Are Manipulated, Good Luck Finding Any Cops

Matthew Leising

December 8, 2014, 7:01 PM EST

The last time regulators took a hard look at how Wall Street trades Treasuries, a little company called Google Inc. was just starting out.

That was 1998, and the technological leaps since then -- including ones that are now transforming bond markets -- have left government overseers in the dust. In particular, executives from three of the biggest market-making firms say an electronic bait-and-switch tactic known as spoofing, which is already the focus of a manipulation allegation at a futures exchange, needs to be investigated in cash Treasuries.

Rules first enacted in 1986 that have gone virtually untouched for a decade and a half are allowing computerized firms to outmaneuver less-savvy rivals and, some executives assert, manipulate prices. They say a lack of cohesive regulation and technology to monitor high-frequency traders is making the world’s biggest government bond market more dangerous for everyone.

“The lack of transparency to the regulators, let alone the public, is the biggest concern,” said Kevin McPartland, head of market structure and research at Greenwich Associates in Stamford, Connecticut. “It feels hypocritical that the government debt market is the one not being looked at.”

The three market-making executives, who asked not to be named because they aren’t authorized to speak publicly, say they have no idea where to take allegations of spoofing in cash Treasuries. No single regulator in that $12.3 trillion market has the authority or expertise to assess evidence of illicit practices such as those in an arbitration case at one of the world’s biggest exchange operators, Chicago-based CME Group Inc., the market makers said.

Feigning Interest

Spoofers try to make money by feigning interest in buying or selling at a certain price, creating the illusion of demand in an attempt to get other traders to move the market. The spoofer cancels the original trade and buys or sells at the new price to make a profit. It’s sometimes called “pull and hit.”

In the CME complaint, a Chicago trading firm called HTG Capital Partners LLC filed an arbitration claim asserting damages from a pattern of canceled bids and offers allegedly meant to mislead traders in Treasury futures, according to people familiar with the matter. Allston Trading LLC, a Chicago-based proprietary trading firm, was identified by CME in that arbitration as a counterparty to the HTG transactions, according to people familiar with the matter. The arbitration is ongoing.

Ellen Resnick, an Allston spokeswoman, declined to comment.

Too Fast

In submissions to the Commodity Futures Trading Commission, CME’s regulator, an executive with one market-making firm presented evidence of near-identical trading patterns in cash Treasuries, according to one of the people. Records show parallel trades occurring in Chicago and the biggest Treasury bond platforms in New Jersey faster than the speed of light permits information to flow between those two locations, the people said.

According to the executives, the trades are evidence of concerted strategies spanning both markets rather than normal reactions to changes in prices. Spoofing in Treasury bonds and related futures contracts has cost traders $500,000 to $1 million a day, an executive at one of the market makers said. Steve Adamske, a CFTC spokesman, declined to comment.

Public scrutiny of Treasury trading has intensified in the weeks since Oct. 15, when a sudden surge in bond prices drove the biggest drop in yields for 10-year notes since 2009. While there’s no evidence the move was driven by manipulation, the event highlights the urgency of understanding what is happening in one of the world’s biggest markets.

Taken Seriously

“Treasury regularly monitors day-to-day movements of financial markets,” Adam Hodge, a spokesman, said in an e-mailed statement. “We take any concern about market manipulation seriously and routinely monitor developments with our regulatory partners. As market mechanics evolve, we will continue to make human capital and infrastructure investments to enhance our ability to stay abreast of market dynamics.”

Craig Pirrong, a finance professor at the University of Houston, compared Treasury bond oversight to the U.S. decision to exempt government securities from provisions in the Volcker Rule, which restricts some types of risky trading at banks.

“The Treasury, Fed, whoever, have always taken a hands-off role with the government securities market,” Pirrong said. “It is rather remarkable that the Fed and Treasury have taken little interest in the dramatic change in market microstructure and trading technology.”

Regulation of U.S. Treasury trading, often described as the largest and most liquid securities market in the world, only came about in 1986 when Congress passed the Government Securities Act.

1998 Study

According to the 1998 joint study by the Treasury Department, Federal Reserve and Securities and Exchange Commission, “the liquidity, integrity, and efficiency of the market are essential for the Department of the Treasury to borrow at the lowest possible cost and for the Federal Reserve System to effectively execute monetary policy.”

Regulation of Treasuries dates back to an era when trading was conducted manually. Now, about half of cash Treasuries volume in institutional markets is done by high-frequency traders, said David Light, co-founder of CrossRate Technologies LLC and former head of rates at RBC Capital Markets. These firms use computers to buy and sell assets in tiny fractions of a second.

The market for trading cash Treasuries by institutional investors is dominated by Nasdaq OMX Group Inc.’s ESpeed system and BrokerTec, owned by ICAP Plc. Earlier this year, ESpeed touted shaving 100 millionths of a second from data delivery to lure traders to its service.

Keeping Pace

Laurie Bischel of CME Group declined to comment. Rob Madden, a spokesman for New York-based Nasdaq, said the company doesn’t comment on specific allegations of manipulation on ESpeed. “We work closely with regulators and other markets across asset classes,” he said. Serra Balls, a spokeswoman for London-based ICAP, declined to comment on potential manipulation.

Regulators have taken steps to keep pace in other markets. The SEC spends about $2.5 million a year on a surveillance system called Midas to help root out bad behavior in the $24 trillion U.S. stock market. The CFTC, the main derivatives regulator in the U.S., requested $115.8 million from Congress this year to fund its market surveillance and enforcement programs.

Hodge Podge

There’s no such system in Treasuries, or any plans to create one. Regulators have authority in a hodge-podge fashion that touches parts of trading, but not the whole. The Treasury Department has the authority to write rules, but not enforce them. That responsibility falls to the SEC if U.S. authorities are alerted to strange trading behavior.

“Understanding the daily movements in the market isn’t that relevant for the Treasury,” said Tony Fratto, who was the department’s chief spokesman during George W. Bush’s presidency. While officials understand automated strategies and how they relate to liquidity, “they’re not regulators of that market,” he said. “No one is.”

Eric Pajonk, a spokesman for the Federal Reserve Bank of New York, declined to comment about the bank’s role in supervising the Treasury market. He referred to the joint study that was published 16 years ago, which says that the Markets Group of the New York Fed has “primary responsibility for day-to-day surveillance of the Treasury securities markets.”

No mention is made of this role for the Markets Group on the New York Fed website today. The monitoring and analyzing it does is to “inform the formulation and implementation of monetary and financial stability policy,” it says.

Treasury Exemption

The SEC has regulatory oversight of broker-dealers that buy and sell Treasury bonds, but U.S. debt is exempt from being defined as a security under the Securities Exchange Act, the U.S. law that gives the SEC its authority, according to John Nester, a spokesman.

Treasury price transactions aren’t published on Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. Finra spokesman George Smaragdis said the group has a rule for Treasury securities that states that no broker or broker-dealer is allowed to “effect any transaction in, or induce the purchase or sale of, any security by means of any manipulative, deceptive or other fraudulent device or contrivance.”

A review of dozens of enforcement cases by the SEC over the past 10 years shows instances of the agency taking action against illegal Ponzi schemes, insider trading and theft of investor money in the cash Treasuries market, but no case alleging trading manipulation such as the tactic alleged in the HTG arbitration.

Finra Cases

Finra’s enforcement record includes actions related to excessive fees charged to customers and failures to execute trades at the best prices for clients. No cases that alleged secondary-market trading manipulation were found.

That leaves the Treasury Department. Its Debt Management office has some responsibility for trading, though Treasury has no authority to take enforcement actions. The department can write rules, and it engages with market users and regulators such as the SEC, but is powerless to go after anyone breaking its own rules.

The Treasury Borrowing Advisory Committee, a group of executives who represent banks and investment funds, meets with Treasury officials each quarter to discuss issues related to the market. At its meeting in November 2013, members brought up high-frequency trading -- a term describing a wide range of automated strategies -- as it relates to the evolution of electronic trading.

‘Noticeable Increase’

Committee members, who weren’t named in the minutes of the meeting, told the group that like stocks and currencies, “fixed income markets had begun to see a noticeable increase to volumes traded electronically.” They added: “Some committee members also suggested that the liquidity provided in the market through electronic trading was small.”

That’s not what brokers say. Two years before the meeting, Michael Spencer, the CEO of ICAP, said that slightly less than 55 percent of the volume on BrokerTec is conducted via high-frequency trading, which is also known as HFT.

The Government Securities Act gave bank regulators the authority to prevent fraud and manipulation in the Treasury market, part of which is a business conduct rule requiring broker-dealers to “observe high standards of commercial honor and just and equitable principles of trade.” That rule was finalized in 1997.

No Flaws

The next year, the Treasury, Fed and SEC said the system was working as intended. “The market continues to function smoothly, and the three agencies do not believe it is flawed in any fundamental sense,” the report said. “As a result, we believe no additional rulemaking authority under the GSA, as amended, is required at this time.”

The 16-year-old study is the most recent assessment of the market the U.S. government has undertaken.

The Treasury Department doesn’t have the tools or computer systems to monitor modern markets, said Fratto, the former government official who’s now a partner in Washington at Hamilton Place Strategies, a banking lobbyist.

“They’re not equipped for that,” he said when asked about the HFT marketplace. “They don’t monitor trade activity. They monitor prices to inform their view of the macro economy,” he said. “They may be afraid to tell you it’s not something they’re very interested in.”

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